Monday, June 26, 2017

Housing: Part 236 - JW Mason throws a truth bomb.

J.W. Mason at John Jay College, City University of New York, who blogs at the Slack Wire posted an outstanding paper in progress (paper is 2nd link in the linked blogpost) about debt, consumption, and business cycles - specifically the Great Recession. He really gets at many of the problems with conventional ways of talking about these things that I have been grappling with, and he addresses them at depth and with new data.

He complains about the standard treatment of aggregate debt as if it is consumer debt. On the idea that income inequality led to debt-fueled unsustainable consumption:

(H)ousehold debt varies positively
with household income; low-income households report very little debt. Mortgages,
student loans, and to some extent auto loans, are specifically middle-income phenomena.
Peak debt-income ratios are found near the high end of the income distribution,
between the 75th and 90th percentile by income. Absolute debt levels rise
monotonically with income. The most natural result of a more unequal distribution
of income, therefore, would be a fall in household debt. Poor households do not
own the assets for which most debt is incurred, and rich households can buy them
outright...More generally, the fact that debt
is primarily incurred to finance asset ownership, not current consumption, must be
the starting point for any discussion of household debt.

He also notes that all of the increase in household consumption in the decades before the Great Recession was from third party and imputed expenditures (public health care, employer health care, imputed owner-occupier rents, etc.) There was no aggregate rise in relative consumption expenditures. He notes:

(T)o the extent consumption trends have diverged from income trends, it has been in
the direction of higher consumption as a share of income among high-income households,
and lower consumption relative to income among lower-income households.
If a mechanism is needed to explain rising consumption demand in the face of more
unequal income in the period before 2007, it should focus on luxury consumption
among the rich - perhaps driven by a wealth effect from capital gains - rather than
on debt-financed consumption among the bottom 95 percent.

Driven by capital gains. Most studies find that consumption inequality has increased by more than income inequality. (And, we know why: Closed Access homeowners are spending their economic rents.)

Mason comments, "As people
get poorer, they don't borrow more, they buy less. This decline in living standards
among lower-income households is reflected in many indicators of health and wellbeing,
such as falling life expectancies. (Case and Deaton, 2015) It is strange that so
many of these writers implicitly deny that income inequality has led to falling living
standards for poor and working class households, but instead has been cushioned by borrowing." I also think it's strange that a nation supposedly increasingly floundering in consumer debt would subsequently engage in a bidding war on the most durable middle class asset class.

As with so many of these papers, I must swoop in and replace his conclusion with my own, using my alternative version of the housing boom. My conclusion would begin with one additional point, which is that rising home values were the result of rising rents in constrained cities, and that capital gains on those homes were capitalized economic rents. There is nothing unsustainable about those gains as long as we continue to limit entry into our productive core urban centers. The reason for the trends Mason finds can be very broadly explained with three groups of households. Legacy Closed Access real estate owners that can realize capital gains and use them for consumption, young highly skilled professionals who had taken out large mortgages to gain access to those Closed Access labor markets and incomes, and households throughout the country with lower incomes who are locked out of those labor markets and who did not take on more debt because they weren't bidding on Closed Access real estate. Those households have stagnant incomes and consumption growth.

I especially appreciate seeing Mason's treatment of debt, cyclically. The vast amount of debt is a claim on an asset, not consumption debt. Equity and debt are two forms of ownership. Equating the shift of ownership from equity ownership toward debt ownership with some sort of recklessness or unsecured debt-fueled consumption leads, in my view, to an incoherent view of debt and business cycles, and I think Mason gets at the root of that problem here.

I see it as broader than a closed-access story. In the past two cycles we have had a more active central bank, which has been willing to keep risk-free rates lower than would otherwise be warranted, for longer. With that backdrop, SOMETHING, will appreciate. First it was the nasdaq, next it was closed-access housing.

At some point the Fed is forced to normalize (or possibly over-normalize) real-rates and valuations must also normalize relative to the underlying cash flows. I believe consumption is asymmetrically sensitive to falls in "wealth," thus you have a recession. Neither the too-high (boom), nor the too-low (bust) valuations are acccurate, hence the boom-bust pattern.

Economists love to explain away every bout of inflation as a supply-shock somewhere in a quest for permanently-easy money. But oddly, they never consider low inflation a possible supply shock (consider shale oil, which may in fact be a temporary boost). I believe if you keep real-rates too low for too long you will eventually get inflation somewhere (and yes, it will look like a supply shock, almost by definition).

Mark, I disagree with practically everything you wrote, and I think the popularity of this view is one reason for our economic malaise. Your first problem is thinking that interest rates are a linear signal of monetary posture. Second, inflation has been low and declining for decades now. At some point that has to mean something to you. Third, because of these myths, credit markets now have been so trampled that home prices don't even reflect low interest rates. Homes are priced as if interest rates are high. I'm sure you think equities are overpriced, too, but they are not. Part of the slight inflation in relative valuations comes from the very low levels of leverage, and even with this low leverage, the equity risk premium is elevated.https://fred.stlouisfed.org/graph/?g=eewVLow interest rates have not been leading firms to take on more leverage. There are supply and demand, and rates are low because there is a quest for safety. Savers want low risk investments, but those investments require either public debt or they require someone to take the equity position, in a house, a firm, etc., and we have imposed public policies to prevent that from happening in various ways.

The average 10-year expected inflation (from TIPS) over the past 15 years has been 2.08%. Monetary policy has been exactly in-line with its goal according to markets.

My argument is not that monetary policy is structurally tight or loose. But rather, that as a result of our ineffective transmission mechanisms (portfolio balance) we need to create a boom-bust financial asset pattern to achieve policy that is correct "on average."

We essentially push up wealth/gdp until it creates demand. And given the low marginal propensity to consume among the very-wealthy, this entails a very large rise in wealth /gdp, which i believe is unstable. When demand appears, monetary policy reverses course as does wealth/gdp. Boom, bust, 2% inflation overall.

I believe (non-city) homes are priced to reflect the dismal earnings prospects of that cohort. Value trap.

The boom/bust problem is created by Closed Access. The low prices of homes in the regional cities and rural areas are low, relative to rent. And, Price/Rent is especially low for low tier properties, because financing has been cut off. If earning prospects were the cause of low prices, this would be reflected in rents. But, rent inflation is high.

I dont think it matters that rent inflation is high. The market knows that there will be a supply response at some point. It's like owning a cyclical equity...sure things might look great...but supply will come.Closed access on the other hand gets priced like a growth stock (or art).

Not saying any of this will continue. But i dont see it as a market malfunction story. It'd be a piece of cake for private equity to buy up "underpriced" homes. Oh wait, they did...and then decided the returns were mediocre.

If you are old enough, you remember a ballplayer named Henry Aaron. The sports-writers (who were pretty good back in those days) used to say, "The problem with Aaron is he should be playing in a higher league."

Erdmann consistently plays above the rest of the bloggers.

Also, I am bright-green with envy that Kenneth Duda notices your blogging and not mine.

PS: Maybe I a weak-brained, but I just watched a Richard Koo presentation, and wondered if he made sense. Koo talks a lot about the build-up debt, and then subsequent balance-sheet recessions. Partly, Koo is convincing as he is such a nice earnest guy, which is different from being correct.

I still think helicopter drops are the way to go, and, of course, unzoning property and eliminating the home-mortgage interest tax deduction. I have to mention legalizing push-cart vending too.